What Are the Moving Averages and How to Use Them?
I am going to write some articles about the different kinds of moving averages and the way they can be used in trading. As you progress in trading, you will be tempted to use many of the fancy strategies that the marketplace is abounding with. But if you ask me, the bias is always towards something that is simple, easy to follow and effective when implemented.
Well, I am currently referring to Moving Averages and how you can use this simple tool to boost your profits in trading. They are ideal in determining trending, corrective or ranging price movements and helps you be better prepared for trade. Many traders even employ multiple moving averages to get a clearer pattern and go for a bigger trade.
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Moving Average: Broad Definition
In the broader market perspective, a simple moving average is an indicator of the market sentiment and traders find it as a useful tool to compare the current rate of closing with previous ones over a specific period. Thus, it essentially is a directional guide for the markets. Chartists normally use these numbers to determine a directional bias, a long-term indicator of price action. Not just for analyzing the price action, these moving averages also help in detailing the buying & selling momentum.
Identifying Support and Resistance Zones
Another key function of moving averages is identifying support and resistance zones. These are the primary barriers against which prices are tested as they are moving up or down. More the number of times they test or try to breach these averages, more the likelihood of a breakout in either direction depending on the market momentum. Similarly, a relatively flat movement around the moving average signals price stabilization and creation of a base for the pieces to bounce higher.
Certain times they are also indicators of the points where a sudden shift in demand is noticed. If you have a significantly high buy or sell orders at this rate, it manifests a directional move in the currency market and potential points of turnaround in the marketplace going forward. Whether you are a seasoned trader or a novice in the market, they serve as a key tool to fashion your future trade and how you can remodel these.
Understanding Simple (SMA) and Exponential Moving Averages (EMA)
Well, first of all let’s understand the various forms of moving averages. SMA stands for Simple Moving Average and EMA signals Exponential Moving Average.
A simple moving average takes a specific number of averages over a certain period where every time frame is equally weighted. However, this could also throw up the possibility of huge price movements higher or lower over the short-term. Perhaps an example can illustrate this concern better. Say we are plotting a five-day moving average of USD-CAD currency pair while the price is on the rise.
Supposing the prices nosedived on one of the five days, the average, therefore, will shift significantly lower, and the overall trend will shift down compared to say a 5-day chart of relatively ranged movement.
So that sure is a problem that needs to be tackled to get a more realistic understanding of the trend chartists uses another form of moving averages, called the Exponential Moving Average. The unique feature of this measure is more weightage is given to the relatively recent prices within the specific time framework. So in the 5-day timeframe that we are considering, the EMA will give a higher weight to the last two days compared to the first two.
Thus, if the spike happened in the first two days, this moving average would not be as badly impacted as the simple moving average. However, the final call is yours. As a trader, you must try out the different averages and see what works best for you.
Traders while using these market indicators must however remember that moving averages are a lagging indicator, and they can confirm a trend only after it has been established, it cannot be used to predict one. What a trader can do is use this as a benchmark to assess future price movements, but a confirmation can be garnered only once the trend is established.
Advantages of Using Moving Averages
Decidedly there are some primary advantages of using the moving averages. Some of the key ones include:
- A fairly simple approach to determine the market trend and the potential of a breakout going forward.
- It helps you smoothen fluctuations due to market rate and deal with the trend implied in an appropriate fashion.
- Depending on the frequency of the rate updates, the potential for market upheavals change and also confirm the swings that might be underway.
- Gives a trader a quick sense of the current trend by simple visualization of the overall price action for a given period.
- Helps you develop the ability to spot opportunities I the market on time and capitalize on these opportunities to the best of your abilities.
- Trading in the direction of a major trend is always an easy way to beat the market odds.
Disadvantages of Using Moving Averages
However, it would be wrong to assume that there are no disadvantages at all. There are sure some fallacies while using this tool to gauge the market momentum:
- Possibility of false signals in case of sudden spike or fall in price.
- Creates noise in market depending on the average charting.
- The time period is crucial for getting a fair sense of market move.
- A longer time period helps you chart relatively strong averages compared to ones for a shorter time.
- You cannot have a definite or absolute number. The averages give you a broad sense of trend and relatively advantageous entry/exit points. But the final call is still yours to spot the exact point to enter and exit in a way it maximizes your returns.
Key Users for Moving Averages
It is particularly useful tool for new traders as it helps them in identifying potential entry points as well as trend direction. Even fund managers and investment bankers use it for analyzing support and resistance zones and potential reversal points. For example, if you are trading the GBP-USD pair and the market trend is strong, any bounce off the 200-day Moving Average, gives you the opportunity to enter a trade. On the other hand, continuous price movement above and below a moving average signals a range and less likelihood of sudden reversal.
Though there are multiple options of averages, it is best to stick to just a few specific moving averages. This works better as you would be more objective about the trend, it starting point, its acceleration and deceleration rather than having too many numbers to work with. Another important aspect is the number of reporting periods that is calculated. It is observed that when there are fewer data points or reporting periods included to calculate the average, the moving average stays relatively close to the spot rate.
In this way, you get a much deeper sense of the overall price action and the underlying market trend. On the contrary, when a moving average is charted taking into account several time periods, the price fluctuation evens out and sometimes a discernible rate trend is ignored in the process. Thus, it is a much better tool to confirm a trend rather than predict one.